Economics: Foundations and Models

Introduction to Economics

Economics is the study of how people make choices to attain their goals, given their scarce resources. Because resources are limited but wants are unlimited, individuals, firms, and governments must make choices, leading to the study of scarcity and trade-offs.

• Scarcity: A situation in which unlimited wants exceed the limited resources available to fulfill those wants.

• Economic Models: Simplified versions of reality used to analyze real-world economic situations.

Key Economic Questions

• What determines the prices of goods and services?

• Why do firms engage in international trade?

• How do government policies affect markets?

1.1 Three Key Economic Ideas

People Are Rational

Economists assume that individuals and firms use all available information to achieve their goals, weighing the benefits and costs of each action to make the best possible decision.

• Example: A firm like Apple sets prices to maximize profit, not randomly.

People Respond to Economic Incentives

As incentives change, so do the actions that people take. Economic incentives can lead to unintended consequences when policies change.

• Example: DNA databases for felons reduced repeat offenses, showing even criminals respond to incentives.

• Application: Changes in student loan policies may incentivize colleges to increase tuition or students to borrow more.

Optimal Decisions Are Made at the Margin

Most decisions involve doing a little more or a little less of something. Economists use marginal analysis to compare the additional benefit and cost of an action.

• Marginal Benefit (MB): The additional benefit from a small increase in an activity.

• Marginal Cost (MC): The additional cost from a small increase in an activity.

• Optimal Decision: Occurs where MB = MC.

1.2 The Economic Problem That Every Society Must Solve

Basic Economic Questions

Every society must answer three fundamental questions due to scarcity:

1. What goods and services will be produced? Trade-offs are necessary; producing more of one good means producing less of another. The opportunity cost is the highest-valued alternative given up.

2. How will the goods and services be produced? Firms choose production methods based on costs and available technology.

3. Who will receive the goods and services produced? Distribution often depends on income, but government policies can alter this distribution.

Types of Economic Systems

• Centrally Planned Economy: The government decides how resources are allocated.

• Market Economy: Households and firms interacting in markets allocate resources.

• Mixed Economy: Most decisions result from market interactions, but the government plays a significant role.

Efficiency and Equity

• Productive Efficiency: Goods and services are produced at the lowest possible cost.

• Allocative Efficiency: Production matches consumer preferences; the last unit provides a marginal benefit equal to marginal cost.

• Equity: The fair distribution of economic benefits. There is often a trade-off between efficiency and equity.

1.3 Economic Models

How Economists Use Models

Economic models are simplified frameworks for analyzing real-world issues. The process of building a model includes:

1. Deciding on assumptions

2. Formulating a testable hypothesis

3. Using data to test the hypothesis

4. Revising the model if necessary

5. Retaining the model for future analysis

Assumptions and Hypotheses

• Assumptions: Simplify reality to make models useful (e.g., consumers maximize well-being, firms maximize profit).

• Hypothesis: A statement about an economic variable that can be tested with data.

Positive vs. Normative Analysis

• Positive Analysis: Concerned with what is (facts and cause-effect relationships).

• Normative Analysis: Concerned with what ought to be (value judgments).

1.4 Microeconomics and Macroeconomics

Distinguishing Microeconomics and Macroeconomics

• Microeconomics: The study of how households and firms make choices, interact in markets, and how the government influences these choices.

• Macroeconomics: The study of the economy as a whole, including inflation, unemployment, and economic growth.

1.5 Economic Skills and Economics as a Career

Skills Gained from Studying Economics

• Analyzing choices and their consequences

• Understanding and applying economic models

• Interpreting data and trends

• Making informed recommendations

Applications in Careers

Economics Majors and Income

Additional info: Higher earnings may be due to skills learned or self-selection of high-earning individuals into economics.

1.6 A Preview of Important Economic Terms

• Technology: The processes a firm uses to produce goods and services.

• Capital: Manufactured goods used to produce other goods and services.

Appendix: Using Graphs and Formulas

Graphs in Economics

Graphs are visual tools that help illustrate economic relationships and trends. Common types include bar graphs, pie charts, and time-series graphs.

Plotting Economic Data

Graphs often plot price on the vertical axis and quantity on the horizontal axis to show relationships such as demand curves.

Calculating Slope

The slope of a line is calculated as the change in the y-axis variable divided by the change in the x-axis variable:

Showing Multiple Variables

Graphs can show how a third variable affects the relationship between two variables, such as how the price of a related good shifts the demand curve.

Positive and Negative Relationships

A positive relationship means both variables move in the same direction; a negative relationship means they move in opposite directions.

Cause and Effect in Graphs

Graphs can illustrate relationships but do not always prove causality. Omitted variables or reverse causality can lead to incorrect conclusions.

Linear and Nonlinear Relationships

Most economic relationships are not perfectly linear. The slope of a nonlinear curve can be approximated over a section or measured at a point using a tangent line.

Formulas in Economics

• Percentage Change:

Areas in Graphs

• Area of a Rectangle (Total Revenue):

  

• Area of a Triangle:

  

Steps for Using Formulas

1. Understand the economic concept the formula represents.

2. Use the correct formula for the problem.

3. Check that the result is economically reasonable.